If you landed in London from another planet this month and picked up the Financial Times's glossy How to Spend It magazine, you would not suspect for a nanosecond that there was a crisis on the world money markets. In 120 pages of unabashed haute consumerism, ads for Tiffany ran alongside features on record couture sales at Christian Dior, with scarcely a hint at harsh realities such as multibillion-pound bank write-offs, smaller bonuses and lost City jobs.

The truth, however, is that in 2007 the financial world was turned upside down: the credit crunch has toppled a golden decade of extraordinary prosperity in the UK and accelerated a shift in the global balance of economic power. One consequence is that banks in the City and Wall Street, the engine rooms of capitalism, have been so desperate for cash that they have sold large chunks of their equity to China or Middle Eastern states.

The credit crunch has spawned plenty of soul searching about financial regulation, debt risks and the like. But more thoughtful financiers acknowledge it has also prompted broader reflection on the City's role in modern Britain.

David Buik of spread betting firm Cantor Index says: 'The day the queues formed outside Northern Rock branches marked a sea change. It was the end of the illusion that we - individuals, companies and governments - could go on running up debt with impunity. It was a wake-up call, particularly for a younger generation which has never known financial hardship, negative equity, high unemployment, never known the economy to be less than benign. It also revealed the truth about our system of financial regulation, that was supposed to be so brilliant, but did not work when put to the test.'

With hindsight, the first signs of a gathering financial storm came early in the year, when HSBC, which owns the former Midland Bank in the UK, admitted that it had written off $10.5bn of bad debts, a large chunk of it on home loans to poor borrowers in America. The bank came in for a huge lashing from its shareholders, but few, at that stage, made the leap to realising it was a much wider problem.

Loans made to cash-strapped American homebuyers had been packaged up into fancy investment vehicles and sold to investors around the world; banks are unsure of the extent of their rivals' - even possibly their own - exposure, and therefore are unwilling to lend to each other.

That matters because it has hit our high-street banks: Northern Rock is being supported by the taxpayer to the tune of £55bn and looks to be heading for nationalisation. It could also hit the wider economy. Mervyn King, governor of the Bank of England, who prides himself on being calm and understated, warned last week of a 'palpable sense of fear' that could send the economy into free fall.

The City has in the past decade turned itself from a comparative backwater into a genuine rival to Wall Street. But the credit crunch means jobs will be lost and bonuses smaller. In Covent Garden, Portland Place and Berkeley Square, the private equity barons, who menaced FTSE 100 companies with audacious takeover bids in the first part of the year, have watched their flood of deals dry to a trickle. On the high street, tills will not be ringing so loudly and, on Acacia Avenue, homeowners are worrying about their mortgages.

Some will see the crisis as an overdue humbling of City arrogance. The past 10 years have been stunningly good for the super-rich. The wealth of high-net-worth individuals (Henwis) - those with at least $1m at their disposal, not counting their main home - increased by 11.4 per cent last year to $37trn worldwide. In the UK, the number of Henwis rose from 448,000 to 485,000; you now need £70m to get into the 'Rich List' of the 1,000 wealthiest people. Much of that wealth inflation has come from the City, with a record 155 financiers making it into the table.

That has fuelled middle-class envy of the very rich, or what Harvard economist Martin Feldstein calls 'spiteful egalitarianism' - the idea that the increasing fortunes of the uber-wealthy are bad, because it makes others feel poor.

The middle classes are resentful because they are being priced out of things they consider their birthright, including homes in desirable areas and good schooling. Private fees, for example, have soared by 41 per cent in five years, taking the average costs of a day school to more than £9,600 a year. The rising costs of education and home ownership, coupled with the urge to consume, has driven record numbers into insolvency (see chart).

Robert and Lisa, a professional couple in their late forties living in London with two sons, are typical of the families caught in the middle-class squeeze. Although prosperous by most standards, they are beset by financial anxieties.

'We live in a five-bedroom terraced house in north London and it has shot up in value since we bought it in 1996,' says Robert. 'But our elder son will soon go to secondary school. To get him into a good one, we'd have to move a short distance and pay an extra £250,000 for the same-sized property near the school. We're thinking seriously about sending both boys to an independent school because the fees are about the same as moving.

'Foolishly, I failed to join company pension schemes in my twenties and thirties and now regret it. We're wondering how we are going to juggle all these financial responsibilities at our age. My parents were not enormously wealthy, but my dad had a good job in an accountancy firm and was always home for supper at 6.30 in time to read us stories. I can't do that with my kids because I have to work such long hours. He lived in London all his life after retiring at 65 on a generous final salary pension scheme - I will have nothing like that.'

Middle-class financial woes could be dismissed as the bleatings of the privileged but, at the bottom end of the economic scale, things are also arguably worse. The rich have become richer, but the poor are still relatively poor. The Institute for Fiscal Studies reported this year that relative poverty has risen for the first time since Labour came to power, with 12.7 million people - more than a fifth of the population - living in households with incomes lower than 60 per cent of the median after housing costs. A shocking 3.8 million children are classed as living in poverty.

Schadenfreude may be satisfying, but a downturn in the City hurts us all, because of the massive increase in its influence on the UK economy as a whole during the golden decade. Financial services has grown from 5.5 per cent of the economy to more than 9 per cent last year and, over the past three years, it has been responsible for a third of overall GDP growth. Manufacturing has gone in the opposite direction, declining as a proportion of the total economy from 23 per cent in 1990 to 14 per cent in 2005. Employment in industry has plunged by more than a million, while financial service sector jobs have grown (see chart).

A report by the Ernst & Young Item Club this year described the City as a 'cuckoo in the nest', crowding out manufacturing and other industries. While it is good to specialise, the report said, this process should be carefully managed. David Frost, director-general of the British Chambers of Commerce, says: 'The government has no option but to nurture the City because it is a huge economic driver. But manufacturing is still important. It is not an either/or situation. You should be able to have both, as they do in Germany, where they still have world-class manufacturers. The economy is like a tripod: you need strong services, strong manufacturing and a strong public sector. Ours is unbalanced, with manufacturing the poor relation.'

The credit crunch has also prompted more soul searching about our high-consumption lifestyle. Edward Bonham Carter, of fund manager Jupiter Asset Management, says: 'In every economic cycle, there are excesses on a local level. People have been much better off in the previous decade, but are they happier? Material accumulation does not improve our sense of well-being, and that is intersecting with the climate change debate, where people realise that they have to consume less. It is part of the zeitgeist.'

Not that he is advocating a hair-shirt backlash: 'The more redistributive you are, the less incentive people have for creating wealth. On the other hand, if you have a rampant capitalist state and do not redistribute it at all, you get rich ghettos and ultimately revolution.'

The other great upheaval of 2007 is the shift in the balance of power from the West to the developing world, seen in the rise of sovereign funds investing trillions of dollars of excess savings from China and the Middle East, a trend that accelerated strongly due to the credit crisis. While Northern Rock was bailed out by the government via the Bank of England, others courted rescue from the Chinese state. Morgan Stanley, for example, received a $5bn injection from the China Investment Corp in return for securities that will convert into as much as 9.9 per cent of its stock. Abu Dhabi's sovereign wealth fund invested $7.5bn in Citigroup last month, and the Singapore government and an unnamed Middle Eastern investor has ploughed SFr13bn (£5.7bn) into Swiss bank UBS.

'When you have a sector that is bombed out but with high growth potential, the smart money piles in,' says one chief executive. 'I think it is a healthy part of globalisation, but there will be more protectionist noise in America about it, which could be harmful.'

Chagrined though they are, leading bankers don't believe their game is up. The same chief executive adds: 'If you take a 10-year view, there is every reason to believe the financial services sector will be one of the fastest growing. Nothing that has happened in the past six months will change some of the big long-term trends, such as the privatisation of the welfare state, or the demographic drivers, such as people living longer. These are behind the development of the financial services industry.'

He goes on: 'The conditions we have now were created by the pursuit for yield by investors in a low-interest, low-inflation environment. Some of the opaque instruments have gone, but the quest for yield has not vanished and that will drive innovation. The performance of markets over time is being pushed by those very big demographic drivers - it is completely unstoppable.'

In the past 10 years, the City has sealed its transformation from a soporific club for paunchy Old Etonians to a magnet for brilliant young talent. It has unleashed innovations on an uncomprehending world and the pace of financial evolution has far outstripped ability of the relatively underpaid, and sometimes intellectually underpowered, financial regulators to keep up.

Sober critics have been questioning the vertiginous rise of the City for some time. During the good times, this was brushed aside by practitioners and politicians, content to bask in the reflected glory of London's rise as a financial centre. After Northern Rock, those inconvenient voices have grown to a clamour that must be heard.

Are we prepared to live in a less equal and more divided society if that is the price of a booming financial sector? Is it OK for the City to play such an overweening role in our economy, while manufacturing struggles? How else, other than in financial services, might Britain compete in a global economy against emerging nations with cheaper labour and raw materials? Is it desirable for the sovereign funds of sometimes undemocratic foreign governments to gain more control over the levers of capital? All of these are issues for 2008 as we ponder how best to move forward in this chastened new world.